Debits and Credits CHAPTER

Transcription

1 3 CHAPTER Debits and Credits As you learned in the last chapter, accountants use the accounting equation to analyze a firm s transactions and determine the effects of those transactions on the firm s assets, liabilities, and owner s equity. You also saw how a firm s financial position is reported on the balance sheet and how the results of the firm s operations for a time period are reported on the income statement. In Chapter, we described accounting as the language of business. Like any other language, accounting has rules and conventions for common usage. In this chapter you will learn the rules used to record changes caused by business transactions. Such records form an essential part of all accounting systems. The accounting cycle is a series of steps performed during each accounting period to analyze, record, classify, and summarize data for a business and produce needed financial information. In Chapter 2, you learned how to analyze the effects of business transactions. In this chapter you will learn to record this information for future use. You will learn to prepare a record of business transactions, to classify financial data, and to summarize the information in the form of financial statements. These written records enable an individual to trace the details of the transaction long after it has happened. New Terms Account balance (page 55) Accounts (page 47) Audit trail (page 49) Chronological order (page 47) Classification (page 47) Compound entry (page 62) Credit (page 46) Debit (page 46) Double-entry system (page 47) Drawing account (page 6) General journal (page 48) Journal (page 47) Journalizing (page 48) Ledger (page 54) Normal balance (page 56) Posting (page 54) T account (page 54) Objectives. Define debit and credit. 2. Describe the relationship between debits and credits, and the accounting equation. 3. Record transactions in the general journal. 4. Post transactions from the general journal to T accounts. 5. Record transactions affecting owner s equity in the general journal. 6. Prepare journal entries.

2 46 UNIT THE ACCOUNTING CYCLE THE RULES OF AND OBJECTIVE Debit = left side; Credit = right side. Debit: An entry on the left side of an account. Credit: An entry on the right side of an account. accounting/fin/trialbalance/ An accounting glossary, which includes definitions of credit, debit, and trial balance. Define debit and credit. Debit is defined as a record of indebtedness. It is related to the word debtor a person who owes a debt. A credit is something entrusted to another. It is related to the word creditor a person to whom a debt is owed. The two words are opposites: one is used to record increases and the other to record decreases in amounts owed to and/or by an organization. The use of debit and credit to describe changes that occur in accounting records is a language convention. Accountants use the words debit and credit to describe actions taken in the accounting records. WHY DO THE TERMS AND SOMETIMES CAUSE DIFFICULTY? The words debit and credit are not used exclusively by accountants. English-speaking people use these terms in common, everyday language. If I say that something is to your credit, what do I mean? Most of us will understand that I mean you have accomplished something worthwhile or honourable. In common usage, a credit is desirable or good. We assume, then, that a debit must be undesirable or bad. Assigning these values to these two terms is what often causes students problems. In accounting, debit and credit are not assumed to be good or bad; they are simply actions performed in the accounting records. Think of them as decreases and increases, not bad and good. DESCRIBE THE RELATIONSHIP BETWEEN S AND S AND THE ACCOUNTING EQUATION OBJECTIVE 2 accounting/fin/doubleentry/ An explanation of the double-entry system. Describe the relationship between debits and credits, and the accounting equation. As you remember from Chapters and 2, the accounting equation can be stated as: Assets = Liabilities + Owner s Equity. Like all equations, the accounting equation must balance. The left side must equal the right side: Left = Right. In accounting terms, the debits and credits must balance. The debits must equal the credits: Debits = Credits. The key to remembering the rules for using debits and credits lies in the accounting equation and the need to remain in balance: Assets = Liabilities + Owner s Equity Left = Right Debits = Credits Assets are on the left side of the accounting equation; increases to assets will be recorded on the left and called debits. Liabilities and owner s equity are on the right side of the accounting equation; increases to liabilities and owner s equity will be recorded on the right and called credits. Since debits and credits are opposites, decreases to assets (on the left side of the accounting equation) will be made on the right and called credits. Decreases to liabilities and owner s equity (on the right side of the accounting equation) will be made on the left and called debits.

3 CHAPTER 3 S AND S 47 Double-entry system: An accounting system that involves recording the effects of each transaction as debits and credits. The analysis of each transaction produces at least two effects. The effect of an entry on the debit, or left side of one account is balanced by the effect of an entry on the credit, or right side of another account. For this reason, the modern system of accounting is usually called the double-entry system. This system involves recording both effects of every transaction to present a complete picture. The balancing relationship also explains why both sides of the equations shown in Chapter are always equal. SELF-REVIEW. On which side of asset, liability, and owner s equity accounts are increases recorded? 2. On which side of asset, liability, and owner s equity accounts are decreases recorded? ANSWERS TO SELF-REVIEW. Increases in asset, liability, and owner s equity accounts are recorded on the same side on which the account appears in the fundamental accounting equation. Increases in asset accounts are recorded on the left side; increases in liability and owner s equity accounts are recorded on the right side. 2. Decreases in asset accounts are recorded on the right side; decreases in liability and owner s equity accounts are recorded on the left side. ACCOUNTS FOR ASSETS, LIABILITIES, AND OWNER S EQUITY Accounts: Written records of a business s assets, liabilities, and owner s equity. Classification: A means of identifying each account as an asset, liability, or owner s equity account. The accounting equation is a tool for analyzing the effects of business transactions. It would be awkward, though, to record every transaction in the equation format if a business had many transactions. Instead, separate written records called accounts are kept for the business s assets, liabilities, and owner s equity. Accounts are kept so that financial information can be analyzed, recorded, classified, summarized, and reported. Accounts are identified by their account classification; that is, as asset accounts (the property a business owns), liability accounts (the debts of the business), or owner s equity accounts (the owner s financial interest in the business). The title of each account describes the type of property, the debt, or the financial interest. JOURNALS Analyzing transactions is the first step in the accounting cycle. Journal: The record of original entry. Chronological order: Organized on a day-to-day basis. Business transactions are recorded in a financial record called a journal, which is a diary of business activities that lists events involving financial affairs transactions as they occur. The transactions are entered in chronological order the order in which they happen day by day. Since the journal is the first accounting record where transactions are entered, it is sometimes referred to as a record of original entry. A number of different types of journals are used in business. The one that will be examined in this chapter is the general journal. As we discuss more complex accounting systems and records in later chapters, you will become familiar with other kinds of journals.

4 48 UNIT THE ACCOUNTING CYCLE THE OBJECTIVE 3 General journal: A permanent, classified record of all accounts used in a firm s operation; a record of final entry. Journalizing: Recording transactions in a journal. free_report_setup_bookkeeping_system.htm Details the importance of and how to set up and maintain a simple bookkeeping system. Record transactions in the general journal. As its name implies, the general journal can be used to record all types of business transactions. The process of recording transactions in the general journal is referred to as journalizing. To illustrate how transactions are entered in this journal, let s start with the first transaction of Arrow Employment Services. When the owner, John Arrow, invested $40,000 on November 6 to start the firm, the transaction was analyzed and the following effects were identified. RECORDING A CASH INVESTMENT Asset accounts record the items of value owned by a business. The location of items in the fundamental accounting equation determines how amounts are recorded in the general journal. The cash investment of $40,000 is entered in the left, or Debit, column of the journal because assets always appear on the left side of the accounting equation. Owner s equity accounts show the financial interest of the owner of the business. The account called John Arrow, Capital, is used to record John Arrow s $40,000 investment. Because owner s equity always appears on the right side of the accounting equation, Viriginia Richey, the office manager, entered the opening balance of $40,000 in the right-hand column of the journal. a. Arrow Employment Services received $40,000 of property in the form of cash. b. John Arrow had a $40,000 financial investment in the business. Using this analysis as a guide, Richey knew that the accounting transaction should be entered as shown in Figure 3-. FIGURE 3- General Journal Entry Record the year first, then the month and day. Record the increase (debit) to cash first. Indent about half an inch and record the increase (credit) to John Arrow, Capital X5 Nov. 6 Cash John Arrow, Capital Beginning investment Write a description of the transaction. Notice that each page in the general journal is given a number and that the year is recorded at the top of the Date column. The month and day are also written in the Date column on the first line of the first entry. After the first entry, the year and month are recorded only when a new page is begun or when either the year or the month changes. However, the day of each transaction is written in the Date column on the first line of each entry. The account to be debited is always recorded first in the Description column. The account title is written close to the left margin, and the debit amount is then entered on the same line in the Debit column.

5 CHAPTER 3 S AND S 49 Audit trail: A chain of references that makes it possible to trace information through the accounting system. The account to be credited is always recorded on the line beneath the debit. The account title is indented about half an inch from the left margin. Next, the credit amount is entered on the same line in the Credit column. A brief explanation follows the credit part of the entry. This explanation begins on the line following the credit. Explanations should be complete but concise. Whenever possible, the explanation for a journal entry should include a description of the source of the information contained in the entry. For example, if a cheque is written to make a payment, the explanation in the journal entry for that transaction should include the cheque number. Similarly, if goods are purchased on credit, the explanation in the journal entry should show the number of the supplier s invoice (bill). These source document numbers are part of an audit trail a chain of references that makes it possible to trace information about transactions through the accounting system. The audit trail helps locate errors in the system. It also helps to prevent fraud because it provides a means of checking the data in a firm s financial records against the original data that appear on the source documents. Usually a blank line is left between general journal entries. This blank line separates the transactions and makes them easier to identify and read. Some accountants prefer to use this blank line to number each general journal entry for identification purposes. RECORDING PREPAID RENT When Arrow Employment Services rented its facilities, the lease specified that eight months rent must be paid in advance. Arrow issued a cheque for $20,000 to make the necessary payment. As a result, the firm obtained the right to occupy the facilities for an eight-month period. This right is accounted for as property an asset. Thus the transaction is analyzed as follows. c. The firm required an asset, totalling $20,000 in the form of prepaid rent. d. The firm paid $20,000 in cash. To record the prepaid rent, an asset called prepaid rent is increased; the $20,000 is entered in the left (debit) column of the journal. Since the cash payment reduced the firm s cash balance, the $20,000 is recorded on the right (credit) to decrease Cash. Explanations should be complete, including document numbers where appropriate to establish an audit trial Nov. 7 Prepaid Rent Cash Paid rent in advance for an eight-month period (Dec. 20X5 through July 20X6), Cheque 00

6 50 UNIT THE ACCOUNTING CYCLE Notice the use of the cheque number in the explanation for the journal entry. This number will form part of the audit trail for the transaction. When Arrow Employment Services purchased equipment on November 9 for cash (Cheque 002), the office manager made the following analysis and then recorded the journal entry that follows. e. The firm purchased new assets in the form of equipment at a cost of $0,000. f. The firm paid $0,000 in cash. To record the purchase of equipment, a new asset, Equipment, was increased by $0,000 by an entry on the left (debit) side of the journal. The payment of $0,000 in cash is entered on the right (credit) side of the journal because decreases in assets are recorded on the right Nov. 9 Equipment Cash Purchased equipment, Cheque 002 RECORDING A PURCHASE OF EQUIPMENT Remember! Liabilities are increased on the right (credit) and decreased on the left (debit). Liabilities are amounts owed by a business to its creditors. Like owner s equity, liabilities always appear on the right side of the accounting equation. Thus the increases to liabilities are recorded in the right column of the journal. On November 0 the business purchased a copy machine, a fax machine, calculators, and other necessary equipment for $5,000 on credit from Organ, Inc., Invoice 2788, payable in 60 days. The transaction was analyzed and the journal entry was recorded as shown below. g. The business purchased new assets (Equipment) at a cost of $5,000. h. The business owed $5,000 as an Account Payable to Organ, Inc. The $5,000 increase in equipment is entered in the left column. The amount owed to Organ, Inc. is recorded as a liability, accounts payable. The $5,000 is entered on the right (credit) column to increase accounts payable because liabilities appear on the right side of the accounting equation.

7 CHAPTER 3 S AND S Nov. 0 Equipment Accounts Payable Purchased equipment on credit from Organ, Inc., Invoice 2788, payable in 60 days 25 Notice how the audit trail is created for this transaction by listing the supplier s invoice number in the explanation for the journal entry. On November 28, when the firm purchased supplies for $,000 in cash (Cheque 003), the transaction was analyzed and the journal entry was prepared as shown below. i. The business purchased new assets (supplies) at a cost of $,000. j. The business paid $,000 in cash. To record this purchase of supplies, an asset, $,000, was entered on the left, or increase side. The payment of $,000 in cash is entered on the right (Credit) column of the journal because decreases in assets are recorded on the right Nov. 28 Supplies Cash Purchased supplies, Cheque 003 A final transaction, the payment of Invoice 2788 for $,000 by Cheque 004 to Organ, Inc. on November 30, was analyzed as shown and the journal entry that follows was made.

8 52 UNIT THE ACCOUNTING CYCLE k. The firm paid $,000 in cash. l. Organ s claim against the firm was reduced by $,000. The decrease in cash (k) is entered on the right (credit). The decrease in the liability (l) is entered on the left (debit) Nov. 30 Accounts Payable Cash Paid Organ, Inc., on account for Invoice 2788, Cheque 004 SELF-REVIEW. In which column of the journal are increases to assets, liabilities, and owner s equity recorded? 2. In which column of the journal are decreases to assets, liabilities, and owner s equity recorded? 3. Why is the journal referred to as the record of original entry? 4. Transactions are entered in the general journal in chronological order. What does this mean? 5. Why are cheque and invoice numbers included in the journal entry explanation? 6. Analyze the following transactions and record the general journal entries that would be made for Rapid Delivery Service. TRANSACTIONS Jan. Jan. 5 Jan. 6 The owner, Ronald Thomas, invested $0,000 in cash. Issued a cheque for $,700 for two months rent. Purchased supplies for $300 on credit. Jan. 7 Purchased office furniture for $5,000.

9 CHAPTER 3 S AND S ANSWERS TO SELF-REVIEW. Increases in asset, liability, and owner s equity accounts are recorded on the same side on which the account appears in the fundamental accounting equation. Increases to assets are recorded on the left; increases to liability and owner s equity accounts are recorded on the right. 2. Decreases to asset accounts are recorded on the right; decreases to liability and owner s equity accounts are recorded on the left. 3. The journal is referred to as the record of original entry because it is the first accounting record in which transactions are entered. 4. Entering transactions in chronological order means they are entered in the order in which they occur day by day. 5. Cheque and invoice numbers are included in the explanation in the journal entry to provide an audit trail that makes it possible to trace information about transactions through the accounting system.

10 54 UNIT THE ACCOUNTING CYCLE Jan. Cash Ronald Thomas, Capital Beginning investment of owner Prepaid Rent Cash Paid for two months rent in advance Supplies Accounts Payable Purchased supplies, on account Office Furniture Cash Purchased furniture for cash 20 LEDGERS Posting to ledger accounts is the third step in the accounting cycle. Ledger: The record of final entry. Posting: Transferring data from a journal to a ledger. T account: A type of account, resembling a T, used to analyze the effects of a business transaction. As you have seen, a journal contains a chronological (day-by-day) record of a firm s transactions. Each entry provides a written analysis of a transaction, showing what accounts should be debited and credited and the amounts involved. With the journal as a guide, data about transactions can be entered in the accounts that are affected. All the accounts together are referred to as a ledger. The process of transferring data from a journal to a ledger is known as posting. Because posting takes place after the transactions are journalized and the ledger is the last accounting record where a transaction is recorded, a ledger is sometimes called a record of final entry. One type of account that accountants use to classify financial information is a T account. This account consists of two lines, one vertical and one horizontal, that resemble the letter T. The title of the account is written on the horizontal (top) line. Increases and decreases in the account are entered on different sides of the vertical line.

11 CHAPTER 3 S AND S 55 T accounts for assets, liabilities, and owner s equity follow. ASSETS LIABILITIES OWNER S EQUITY Record Record Record Record Record Record increases decreases decreases increases decreases increases Debits Credits Debits Credits Debits Credits POSTING TO THE LEDGER OBJECTIVE 4 About Accounting: Refinement of the realignment How can my company be run better? Sometimes it takes an accounting consultant to determine how a company can become more competitive. Account balance: The difference between the amounts recorded on the two sides of an account. Post transactions from the general journal to T accounts. To understand the posting process, examine Figure 3-2. On November 7, 20X5, the office manager for Arrow Employment Services made an entry in the general journal to record the payment of rent in advance for an eight-month period. Next, the data from the journal were posted to the proper account in the ledger. The debit amount in the journal was transferred to the Debit column in the Prepaid Rent account and the credit amount in the journal was transferred to the Credit column in the Cash account. An account balance is the difference between the amounts recorded on the two sides of an account. It is computed by first adding the figures on each side of the account. When the column is added, the total is entered in small pencil figures called a footing. The smaller total is subtracted from the larger one, and the result is the account balance. If the total of the figures on the right side is greater than the total on the left side, the balance is recorded on the right side. If the total of the figures on the left side is greater, the balance is recorded on the left side. If an account contains only one amount, that figure is the balance. If an account contains entries on only one side, the total of those entries is the account balance. FIGURE 3-2 Posting to the General Ledger X5 Nov. 7 Prepaid Rent Cash Paid rent in advance for an eight-month period (Dec. 20X5 through July 20X6), Cheque 00 20, Prepaid Rent Cash 20,000.00

12 56 UNIT THE ACCOUNTING CYCLE For example, the total of the figures on the left side of Arrow Employment Service s Cash account on November 30, 20X5, is $40,000. The total of the figures on the right side is $32,000. By subtracting the footing of $32,000 from $40,000, we obtain the account balance of $8,000. The account balance is recorded on the increase (left) side of the account. The account balance for Cash is shown below. Cash + (a) 40,000 (d) 20,000 (f ) 0,000 (j),000 (k),000 Bal. 8,000 32,000 Footing Normal balance: The increase side of an account. The balance of an account is normally recorded on the increase side of the account. The increase side of the account is the normal balance of the account. The increase side of an account depends on whether the account is classified as an asset, liability, or owner s equity account. A summary of the procedures to increase or decrease accounts and the normal balance of accounts in the basic accounting equation follows. ASSETS = LIABILITIES + OWNER S EQUITY Increase Decrease Decrease Increase Decrease Increase (Normal Bal.) (Normal Bal.) (Normal Bal.) Debits Credits Debits Credits Debits Credits A summary of the account balances for Arrow Employment Services is shown in Figure 3-3. The firm s position after these transactions can be given in equation form. Assets = Liabilities + Owner s Equity Prepaid Accounts John Arrow, Cash + Supplies + Rent + Equipment = Payable + Capital $8,000 + $,000 + $20,000 + $5,000 = $4,000 + $40,000 A formal balance sheet prepared for November 30, 20X5, is shown in Figure 3-4. ACCOUNTS FOR REVENUE AND EXPENSES OBJECTIVE 5 Record transactions affecting owner s equity in the general journal. Some owner s equity accounts can be further classified as revenue or expense accounts. Many business transactions involve revenue and expenses. Separate accounts are used to record these amounts. Let s examine the revenue and expense transactions of Arrow Employment Services for December to see how they are recorded.

13 CHAPTER 3 S AND S 57 FIGURE 3-3 T-Account Balances for Arrow Employment Services ASSETS = LIABILITIES + OWNER S EQUITY Cash Accounts Payable John Arrow, Capital (a) 40,000 (d) 20,000 (I),000 (h) 5,000 (b) 40,000 (f ) 0,000 Bal. 4,000 (j),000 (k),000 Bal. 8,000 32,000 Supplies + (i),000 Prepaid Rent + (c) 20,000 Equipment + (e) 0,000 (g) 5,000 Bal. 5,000 FIGURE 3-4 Balance Sheet for Arrow Employment Services ARROW EMPLOYMENT SERVICES Balance Sheet November 30, 20X5 Assets Liabilities Cash $ Accounts Payable $ Supplies Prepaid Rent Owner s Equity Equipment John Arrow, Capital Total Assets $ Total Liabilities and Owner s Equity $

14 58 UNIT THE ACCOUNTING CYCLE RECORDING REVENUE FROM SERVICES SOLD FOR CASH During December the business earned a total of $0,500 in revenue from clients who paid cash for services. The office manager made the following analysis. m. The firm received $0,500 in cash. n. The owner s equity increased by $0,500 because of this inflow of assets from revenue. ENTRIES FOR DECEMBER About Accounting: The Story of Your Life? The general journal is similar to a personal diary. You write all types of business transactions in it. The general journal details, in chronological order, the economic events of the business. How is the increase in owner s equity recorded? One way would be to record the $0,500 in the John Arrow, Capital account. However, the preferred way is to keep the revenue figures separate from the owner s investment until the end of the month or until financial reports are prepared. Therefore, Viriginia Richey opens a new account called Fees Income (a revenue account). Remember that revenue is a subdivision of owner s equity. At this point in its operations, Arrow Employment Services needs just one revenue account, which is called Fees Income. The title of this account describes the specific type of revenue recorded in it. The revenue subdivision is used to classify and summarize various kinds of revenue of a business. The $0,500 of revenue is entered in the right column of the journal because revenue increases owner s equity and an owner s equity account is increased on the right side. Since the right side of the revenue account is used to record increases, the left side is used to record decreases. Decreases in a revenue account may be required by corrections, by transfers to other accounts, or by refunds. However, such entries are not required often. Different accounts are used for different types of revenue. For instance, in a business where goods are sold, an accountant would set up a revenue account called Sales. When more than one revenue account is used, the accounts are classified under the heading Revenue on the income statement, and the total of their balances would be the total operating revenue of the business for the accounting period X5 Dec. 3 Cash Fees Income Performed services for cash RECORDING REVENUE FROM SERVICES SOLD ON During December Arrow Employment Services also earned revenue of $3,500 from charge account clients. The office manager s analysis showed the following effects. o. The firm obtained a new asset accounts receivable of $3,500. p. The owner s equity was increased by $3,500 of revenue.

15 CHAPTER 3 S AND S 59 To record this transaction, Richey first opened a new asset account called Accounts Receivable and entered the $3,500 in the left (increase) column of the journal. Richey entered the $3,500 increase in owner s equity on the right (increase) Dec. 3 Accounts Receivable Fees Income Performed services on credit RECORDING COLLECTIONS FROM ACCOUNTS RECEIVABLE When charge account clients paid a total of $,500 to apply to their accounts, Richey made the following analysis. q. The firm received $,500 in cash. r. Accounts receivable decreased by $,500. Recording this information involved the use of two asset accounts. Richey entered the $,500 increase in Cash in the left column of the journal and the $,500 decrease in Accounts Receivable on the right. Notice that there is no revenue from this transaction. The revenue was entered when the sales on credit were recorded (p) Dec. 3 Cash Accounts Receivable Received cash from credit clients on account RECORDING AN EXPENSE FOR SALARIES Like other firms, Arrow Employment Services had expenses in running its business. The first expense was for employees salaries of $2,500. The office manager determined that this expense had the following effects. s. The payment of $2,500 for salaries reduced the asset Cash. t. Expenses increased by $2,500, specifically the Salaries Expense account. The decrease in Cash is recorded in the right column of the journal.

16 60 UNIT THE ACCOUNTING CYCLE The decrease in owner s equity that results from the expense could be debited to John Arrow, Capital. However, the preferred method is to keep expenses separate from the owner s equity account until the end of the month, or until financial reports are prepared. Like revenue, expenses are a subdivision of owner s equity. This subdivision is used to classify and summarize the various costs of operating the business. A new account called Salaries Expense is opened for Arrow Employment Services. The account title describes the specific type of expense recorded in the account. The $2,500 for salaries is entered in the left column of the journal because expenses decrease owner s equity and an owner s equity account is decreased on the left side. Remember that an increase in an expense brings about a decrease in owner s equity Dec. 3 Salaries Expense Cash Paid monthly salaries to employees, Cheques Other kinds of expenses will be recorded in separate accounts, each with its own descriptive title. For example, the payment of monthly utility bills will be recorded in an account called Utilities Expense. Salaries Expense and Utilities Expense are classified under the heading Expenses on the income statement. The total of all such account balances is the total operating expenses of the business for the accounting period. RECORDING AN EXPENSE FOR UTILITIES During December Arrow Employment Services also had an expense of $300 for utilities, which it paid by issuing a cheque. Richey made the following analysis of this transaction. u. The payment of $300 for utilities reduced the asset Cash. v. The account Utilities Expense was increased by $300. The reduction in Cash (u) was recorded by an entry in the right (credit) column in the journal. Increases in expenses are recorded on the left because expenses reduce owner s equity. Decreases in expenses are recorded on the right. Decreases in expenses may result from corrections, transfers to other expense accounts, or refunds. However, such entries are not required often.

17 CHAPTER 3 S AND S Dec. 3 Utilities Expense Cash Paid monthly bill for utilities, Cheque 007 THE DRAWING ACCOUNT Drawing account: A special type of owner s equity account set up to record the owner s withdrawal of cash from the business. In sole proprietorships and partnerships, the owners do not pay themselves salaries. To obtain funds for personal living expenses, owners make withdrawals of cash against previously earned profits that have become part of their capital or against profits that are expected in the future. A special type of owner s equity account called a drawing account is set up to record these withdrawals. Since withdrawals of assets decrease owner s equity, withdrawals can be debited to the Capital account. However, the preferred method is to separate withdrawals from the owner s equity account until the end of the accounting period. On December 30, 20X5, John Arrow withdrew $,000 in cash from the business to pay for personal expenses. The effect of the withdrawal is shown below. w. Cash was reduced by the $,000 withdrawal. x. The amount of cash the owner withdrew from the business increased by $,000. The decrease in cash is recorded with an entry in the right (credit) column of the journal. To record the increase in withdrawals, the $,000 is entered in the left (debit) column of the journal. The balance of the Drawing account decreases the Capital account and is reported on the statement of owner s equity as withdrawals for the period Dec. 3 John Arrow, Drawing Cash Owner withdrew cash for personal expenses, Cheque

18 62 UNIT THE ACCOUNTING CYCLE OBJECTIVE 6 Compound entry: A journal entry that contains more than one debit or credit. Remember! No matter how many accounts are involved, the total debits must equal the total credits in each entry. bookkeep.html#l This article, written for business owners, details the importance of financial records. Advice and tips on using computerized accounting software and converting to a computerized system are offered. COMPOUND ENTRIES Prepare journal entries. Each of the journal entries shown so far consists of a single debit and a single credit. However, some transactions require a compound entry a journal entry that contains several debits or several credits. In a compound entry all debits are recorded first followed by the recording of the credits. Suppose that when Arrow Employment Services purchased the equipment on November 9 for $0,000, John Arrow provided $5,000 in cash (Cheque 002) and agreed to pay the balance in 30 days. This transaction would be analyzed as follows.. An asset, Equipment, is increased by $0, An asset, Cash, is decreased by $5, A liability, Accounts Payable, is increased by $5, The compound entry shown below would be entered in the general journal. 20X5 Nov. 9 Equipment Cash Accounts Payable Purchased equipment on credit from Organ, Inc., Invoice 2787, issued Cheque 002 for a $5,000 down payment; bal. due 30 days Notice that this compound entry contains equal debits and credits, just as any journal entry should ($0,000 = $5,000 + $5,000).

19 CHAPTER 3 S AND S 63 3 CHAPTER Review and Applications CHAPTER SUMMARY Objective : Define debit and credit. A debit is an entry on the left side of an account; a credit is an entry on the right side of an account. Objective 2: Describe the relationship between debits and credits, and the accounting equation. Assets = Liabilities + Owner s Equity Left = Right Debits = Credits Assets are on the left side of the accounting equation; therefore, increases to assets are made on the left side of asset accounts and are called debits. Decreases to assets are made on the right side of asset accounts and are called credits. Liabilities and owner s equity are on the right side of the accounting equation; therefore, increases to liabilities and owner s equity are made on the right side of liabilities and owner s equity accounts and are called credits. Decreases to liabilities and owner s equity are made on the left side of liabilities and owner s equity accounts and are called debits. Objective 3: Record transactions in the general journal. Record the year and month at the top of the Date column. Write the day in the Date column on the first line of each entry. Record the account to be debited in the Description column close to the left margin, then enter the debit amount on the same line in the Debit column. Record the account to be credited on the line beneath the debit, indented about half an inch from the left margin, then enter the credit amount on the same line in the Credit column. Enter a complete, but concise explanation on the line following the credit. Leave a blank line between journal entries. Objective 4: Post transactions from the general journal to T accounts. Copy the debit amount in the journal to the Debit column in the ledger account specified in the Description column. Copy the credit amount in the journal to the Credit column in the ledger account specified in the Description column. Objective 5: Record transactions affecting owner s equity in the general journal. Owner s equity accounts are divided into revenue, expense, and drawing accounts. Revenue accounts increase owner s equity; therefore, increases are recorded on the credit side of revenue accounts. Expenses are recorded on the debit side of the separate expense accounts because expenses decrease owner s equity. The Drawing account is used to record the withdrawal of cash or other assets from the business by the owner. Like expenses, the Drawing account decreases owner s equity.

20 64 UNIT THE ACCOUNTING CYCLE Objective 6: Prepare journal entries. A compound journal entry contains several debits or several credits. In a compound entry all debits are recorded first, followed by the credits. Just as any journal entry must, a compound entry contains equal debits and credits. REVIEW QUESTIONS. What are accounts? 2. Why is prepaid rent considered an asset account? 3. Why is the modern system of accounting usually called the double-entry system? 4. The terms debit and credit are often used in describing the effects of transactions on different accounts. What do these terms mean? 5. Decide whether each of the following types of accounts would normally have a debit balance or a credit balance. a. An asset account b. A liability account c. The owner s capital account d. A revenue account e. An expense account 6. How is the balance of an account determined? EXERCISE 3- (Obj., 2, 3) EXERCISE 3-2 (Obj. 2) EXERCISES Analyzing transactions. Kathy Nelson decided to start her dental practice. The first five transactions for the business are listed below. For each transaction, () determine which two accounts are affected, and (2) prepare journal entries without explanations and dates to record the transactions.. Kathy invested $20,000 cash in the business. 2. Paid $5,000 in cash for equipment. 3. Performed services for cash amounting to $2, Paid $700 in cash for one month s rent expense. 5. Paid $500 in cash for supplies. Identifying debits and credits. Determine whether the word debit or credit is correct for each space in the sentences below.. Asset accounts normally have? balances. These accounts increase on the? side and decrease on the? side. 2. Liability accounts normally have? balances. These accounts increase on the? side and decrease on the? side. 3. The owner s capital account normally has a? balance. This account increases on the? side and decreases on the? side.